POLLUTION CHARGES FOR ENVIRONMENTTAL PROTECTION: A POLICY LINK BETWEEN ENERGY AND ENVIRONMENT ppt

Traditional Mechanisms Versus Market-Based Incentives The policy maker's task separates into two parts, the choice of the overall goal and the selection of a means or “instrument” to ac

POLLUTION CHARGES FOR

ENVIRONMENTAL

PROTECTION: A Policy Link

Between Energy and

Environment

Robert N Stavins

John F Kennedy School of Government, Harvard University, Cambridge,

Massachusetts 02138 and Resources for the Future, Washington, D.C 20036

Bradley W Whitehead

McKinsey & Company, Inc., Cleveland, Ohio 44114-1873

KEY WORDS: market-based environmental policies, economic incentives, pollution taxes, green

taxes, incentive-based environmental policies

CONTENTS

MARKET-BASED INCENTIVES FOR ENVIRONMENTAL PROTECTION 188 New Environmental Challenges 0.0.0 0 0 eens 188 Tradittonal Mechanisms Versus Market-Based lnceHives _., T89 POLLUTION CHARGES: WHAT THEY ARE AND HOW THEY WORK 193 The Mechanics of Pollution Charge Systems bee eee ee 194

Comparing Charges with Tradeable Permits 0.000.000 ees 196 APPLICATIONS OF POLLUTION CHARGES_ 198 Greenhouse-Gas ÑedWCIONS Ặ QQ Q Q Q Q Q HQ LG eee teens 198 Cleaner Energy Production: Environmental Costing at Electric Utilities 202 Other Applications of Polluton Charges 204

*Stavins is an Associate Professor of Public Policy and a Senior Research Associate, Center for Science and International Affairs, at the John FE Kennedy School of Government, Harvard University, and a University Fellow of Resources for the Future; Whitehead is a Management Consultant for McKinsey & Company, Inc

lD

~MARKET-BASED INCENTIVES FOR

ENVIRONMENTAL PROTECTION

Environmental awareness 1s at an all-time high among the public in the United

States (1) In the 1970s, such awareness led to landmark legislation to improve

the quality of our air, land, and water In the 1990s, much of this legislation

is before the Congress for reauthorization and the nation is poised to address

old and new environmental problems The lessons learned and the limitations imposed by increasingly scarce resources, however, have altered the perspec-

tives from which citizens and policy makers are seeking solutions that are

less costly, require less government intervention, and push technological

development further than conventional policies

This article examines pollution charges, a set of environmental policy instruments that are receiving increased consideration in discussions of many environmental issues Our purpose here is not to survey—comprehensively or otherwise—the extensive economic literature on pollution charges, which dates back at least to the early 1970s.' Rather, our purpose is to provide a

brief introduction and overview for researchers and practitioners working in

other disciplines of some current thinking on pollution charges and related market-based environmental policy mechanisms in the highly political context

of contemporary policy deliberations

New Environmental Challenges

Historically, US environmental policy has been characterized by a belief that government must compel the market to “behave” environmentally, no matter what the cost, by regulating market forces Although this approach has produced environmental progress over the past two decades, it has not been without significant side-effects In particular, this approach has placed unnecessary cost burdens on the economy, has stifled the development of new, more effective environmental technologies, and has engendered excessive litigation and other forms of conflict among regulators, environmentalists, and private industry As aresult, today’s policy makers face the challenge of finding ways to “do more with less” while harnessing, rather than obstructing, market forces

DOING MORE WITH LESS: THE NEED FOR COST-EFFECTIVENESS Environmental

protection can no longer be considered in isolation from its costs This stems

in large part from the sheer magnitude of environmental protection expendi- tures as well as heightened concern over international competitiveness and excessive government intervention The US Environmental Protection Agency

'A C Pigou is generally credited with developing the idea of a corrective tax to discourage activities that generate what economists call “externalities,” such as environmental pollution See

Pigou (1a) A review of practical design and implementation was provided by Russell (1b).

(EPA) estimates that more than $100 billion is now spent annually by the

US economy to comply with federal environmental laws and regulations “In

terms of government outlays, federal, state, and local budget deficits make it less likely that environmental protection can be increased simply by spending

more money on programs and policies already in place Citizens are also

recognizing the limits of financial resources, as witnessed by the failure of several environmental initiatives in recent elections

The increased caution about the degree and type of regulatory burdens

placed upon businesses, entrepreneurs, and citizens does not imply that citizens and policy makers have stopped worrying about the benefits of environmental protection To the contrary, environmental concerns continue to surface as major public preoccupations Instead, the concern is reflected as a desire for cost-effective mechanisms To some, this means getting more environmental

protection for the same level of expenditures To others, it means getting the same level of protection for less cost To both, it means making the most of scarce resources and maximizing returns on environmental investments

HARNESSING, NOT OBSTRUCTING, MARKET FORCES’ The market has histori-

cally been viewed as the principal villain in the pollution “tragedy”; its forces have been blamed for driving firms to ignore the environmental consequences

of their activities According to this viewpoint, market forces must be checked; the government should make decisions that the market cannot or will not make for itself As a result, the government’s proper role has been defined as both setting the goals of policy and intervening in the production process itself by

specifying technologies and procedures

Political leaders are coming to recognize, however, that market forces are not only part of the problem, but also a potential part of the solution Stopping market forces would not only be virtually impossible, but most likely counterproductive Policies are needed that mobilize and harness the power

of market forces on behalf of the environment, making economic and

environmental interests compatible and mutually supportive (3, 4)

Traditional Mechanisms Versus Market-Based Incentives

The policy maker's task separates into two parts, the choice of the overall

goal and the selection of a means or “instrument” to achieve that goal (5).°

"This estimate excludes environmental activities not directly associated with pollution control

or cleanup, such as wildlife conservation and land management The $100 billion estimate covers

spending by private business (63.0%), local governments (22.5%), the federal government (11.0%), and state governments (3.5%) For further discussion, see (Ic) Jorgensen & Wilcoxen

(2) provide a recent analysis of the impact of environmental regulation on productivity

In practice, of course, the two tasks are linked within the political process because both the choice of the goal and the mechanism for activating it have important political ramifications.

This paper focuses on the latter task-—meeting a given goal or standard at minimum cost—although issues of efficiency—selecting that goal that

maximizes the difference between benefits and costs—are also considered

Before investigating market incentives, in general, and pollution charges, in particular, it 1s useful to review the regulatory approach most frequently

mand-and-control regulations tend to force all firms to behave in the same way when it comes to pollution, shouldering identical shares of the pollution- control burden regardless of their relative costs Government regulations typically set uniform standards for all firms; the most prevalent standards are technology- and performance-based standards As the name suggests, technol- ogy-based standards specify the method, and sometimes the equipment, that firms must use to comply with a regulation.“ In one case, all firms in an industry might be required to use the “best available technology” to control water pollution; in a more extreme example, electric utilities may be required

to utilize a specific technology, such as electrostatic precipitators, to remove

particulates Performance standards, on the other hand, set a uniform control

target for all firms while allowing them some latitude in how they meet it

Such a standard might set the maximum allowable units of pollutant per time

period, but be neutral with respect to the means by which each firm reaches

this goal.>

Holding all firms to the same target can be both expensive and counterpro- ductive Although uniform standards can sometimes be effective in limiting emissions of pollutants, these standards typically do so at relatively high costs

to society Specifically, such standards can force some firms to use unduly expensive means of controlling pollution.® The reasons are simple: the costs

of controlling emissions can vary greatly between and even within firms, and the right technology in one situation may be wrong in another Indeed, the

cost of controlling a given pollutant may vary by a factor of 100 or more

“Usually, regulations do not explicitly specify the technology, but establish standards on the basis of a particular technology In situations where monitoring problems are particularly severe, however, technologies are specified

“The text provides only a brief and very general description of the nature of conventional policy approaches For a detailed description—on a case-by-case basis—of existing command- and-control instruments, see Portney (6)

‘In a survey of eight empirical studies of air-pollution control, Tietenberg found that the ratio

of actual, aggregate costs of the conventional, command-and-control approach to the aggregate costs of least-cost benchmarks ranged from 1.07 for sulfate emissions in the Los Angeles area

to 22.0 for hydrocarbon emissions in all domestic DuPont plants See Tietenberg (7).

among sources, depending upon the age and location of plants and the available technologies.’

This regulatory approach also tends to freeze the development of technol- ogies that could provide greater levels of control Little or no financial incentive exists for firms to exceed their control targets; the system may also

discourage experimentation with new technologies In fact, a firm’s reward for developing a new technology may be that it will subsequently be held to

a higher standard of performance As a result, financial resources that could

be invested in technology development are diverted to legal battles over what are or are not acceptable technologies and standards of performance

MARKET-BASED INCENTIVES Market-based incentives equalize the level of

marginal costs of compliance among firms, rather than each firm’s level of

control.’ They do so by transferring more of the pollution control burden to firms with low costs of control The result is that for a given level of aggregate

control, fewer total economic resources are used (or more pollution control

can be achieved for the same level of resources)

While the precise mechanics of market incentives vary by type, they share

a basic underlying principle Simply stated, the government imposes financial

incentives (or disincentives) on pollution-related activities that make it in the

self-interest of firms and individuals to behave in socially desirable ways In

effect, these systems ensure that environmental costs imposed on society are

factored into decision making, i.e.—in the language of economists—they

“internalize externalities.” Thus, the more costly the government makes it to pollute, the more likely firms are to prevent pollution before it happens The extent to which they will do so depends on their internal costs of control

relative to the disincentive (or incentive) A firm with low marginal costs of controlling pollution could therefore be expected to control more than a firm

with high costs Furthermore, firms will choose the pollution reduction path

most appropriate to their situation, whether that be the implementation of control devices, new production processes, a changed product mix, or the development of new technologies The central role of the government ts to

establish incentives so that costs incurred by firms are sufficient to achieve

"Numerical examples of the variance of incremental costs of air-pollution control are provided

by Crandall (7a) |

"The marginal costs of pollution control are the additional or incremental costs of achieving

an additional unit of pollution reduction If these marginal costs of control are not equal across sources, then the same aggregate level of pollution control could be achieved at lower overall cost simply by reallocating the pollution control burden among sources, so that the low-cost controllers controlled proportionately more and the high-cost controllers controlled proportionately less Additional savings could theoretically be achieved through such reallocations until marginal costs were identical at all sources.

the desired level of aggregate pollution control, and—as with any regulatory system—to monitor compliance and enforce the law

A common misperception of incentive systems is that they represent a laissez-faire, free-market approach This is not the case They recognize that market failures are typically at the core of pollution problems, but they reject the notion that such failures justify “scrapping” the market system and dictating firm or consumer behavior Instead, they ensure that environmental consequences are reflected in decision making, but provide a degree of freedom

of choice to both businesses and consumers when selecting the best way to reduce pollution Incentive-based regulations thus harness rather than impede market forces and channel those forces to achieve environmental goals at the lowest possible cost to society at large Furthermore, they make the environ- mental debate more understandable to the general public by allowing political attention to be focused on what our environmental goals should be, rather than

on difficult technical questions about different means for reaching these goals.” Economic-incentive systems can be thought of at the broadest level as falling into four categories:

1 Pollution Charges Producers of pollution are charged a fee on the amount

of pollution they generate A subset of this category are deposit-refund systems, within which an initial charge (or some portion thereof) is

rebated if certain actions are undertaken

2 Tradeable Permit Systems The government establishes an overall level of

allowable pollution and then allots this in the form of permits among

firms Firms that keep their emissions below the allotted level may sell

or lease their surplus permits to other firms or use them to offset excess

emissions in other parts of their own facilities (8)

3 Removal of Market Barriers In some cases, substantial gains can be made

in environmental protection simply by removing existing government- mandated barriers to market activity For example, measures that facilitate the voluntary exchange of water rights can promote more efficient allocation and use of scarce water supplies, while curbing the need for expensive and environmentally disruptive new water-supply projects (9)

economically inefficient and environmentally unsound development A major example is provided by the US Forest Service’s “below-cost timber

sales,” which recover less than the cost of making timber available (10).!°

*For an analysis of the problems of EPA’s historical focus on technical questions, see Landy,

Roberts, and Thomas (7b)

‘Other examples of economically inefficient and environmentally disruptive subsidies include those associated with US Army Corps of Engineers flood control projects, US Bureau of Reclamation projects, and Bureau of Land Management and Forest Service public lands grazing programs On these, see (5).

These subsidies encourage excessive timber cutting, which leads to substantial loss of habitat and damage to watersheds

CHOOSING BETWEEN TRADITIONAL MECHANISMS AND MARKET-BASED INCEN-

TIVES Both command-and-control and incentive-based mechanisms serve a

purpose in environmental protection Command-and-control approaches tend

to be more applicable in situations that involve highly localized effects and threshold damages and where concern thus focuses on the level of pollution emitted by individual sources Incentive-based systems, on the other hand, are most appropriate for problems of aggregate pollution over relatively large areas (e.g acid rain and global climate change), since less control is exercised

over the emissions of any specific site

The primary advantage of market-based incentives is their cost-effective- ness; however, cost-effectiveness is not the sole criterion policy makers should

use to evaluate existing or proposed policies The notion of fairness or equity

is prominent among the other major criteria, which include information requirements, monitoring and enforcement capability and costs, political feasibility, and clarity to the general public (11, 11a) Most environmental policies require some trade-off between economic efficiency or cost-effec-

tiveness and equity Even when the aggregate benefits of a policy greatly

exceed its aggregate costs, there are usually some individuals or firms who

are made worse off

Whether such groups should be compensated as part of policy design is, to

a large degree, a political question Its answer will depend upon alternative

notions of fairness What is important is that mechanisms do exist for providing

compensation to those affected by incentive-based policies, if this is deemed appropriate In general, when some form of adjustment is merited, it may be

desirable to link it to the nature of the harm done (12) For instance, if a

policy raises energy prices, these may impose a particular burden on low-income households The response in such a case may be to implement

“lifeline” rates for initial increments of energy use If employees are displaced, job-search and job-training programs can soften the impact When the Clean Air Act was reauthorized in 1990, a program was established to provide job-training and other forms of compensation for workers displaced by the

new law, at an estimated cost of $250 million over five years (13)

POLLUTION CHARGES: WHAT THEY ARE AND HOW THEY WORK

This section describes the mechanics of pollution charge systems, reviews

our experience with them, discusses ways to use the revenues collected, and

compares charges with tradeable permits

The Mechanics of Pollution Charge Systems

Charge systems reduce polluting behavior by imposing a fee or tax on polluters Ideally, the fee should be based upon the amount of pollution they

generate, rather than on their pollution-generating activities.'' In some cases,

however, it may be based upon the expected or potential quantity of pollution

The Organization for Economic Cooperation and Development (OECD)

distinguishes five types of pollution charges: effluent charges, based upon the quantity of discharges; user charges, such as payments for public treatment facilities; product charges, which are based upon the potential pollution of a product; administrative charges, which are payments for government services such as registration of chemicals; and tax differentiation, which provides more favorable prices for “green” products (14)

A true pollution charge provides incentives to firms (or consumers)!” to

reduce “emissions” by modifying their decision making In the presence of a pollution charge, firms will reduce pollution when that is the less expensive option, and they will pay the pollution charge when that is less costly Firms will reduce pollution up to the point at which their marginal costs of control

are equal to their pollution-tax rates As a result, firms will control to different

degrees; firms with high marginal costs will control less, and those with low costs will control more

Charge systems force firms to internalize the externalities they create in the course of production Pollution poses real costs to society (for example, health consequences, property damages, and aesthetic impacts), but firms typically do not have to pay for these damages and hence face little or no incentive to take them into account in production decisions Pollution charges place an explicit value on these “external” consequences and force firms to recognize and pay for them or the cost of avoiding them

Pollution charges also provide strong incentives for firms to develop and adopt new, improved control technologies (15) Under command-and-control, firms face little financial incentive to perform better than the standard Pollution charges, however, do not specify a technology or a fixed standard Charges are incurred for each increment of pollution (rather than only for

pollution above a standard), motivating firms to improve their financial

''For example, a pollution charge might take the form of a charge per unit of sulfur dioxide emission, not a charge per unit of electricity generated The choice of whether to tax pollution quantities, activities preceding discharge, inputs to those activities, or actual damages depends on trade-offs between costs of abatement, mitigation, damages, and program administration, including monitoring and enforcement

Pollution charges can be applied either to producers or consumers In the rest of the chapter,

we refer only to firms (and production), although the same concepts apply to consumers.

performance by developing technologies that allow them to increase their pollution control

Identifying the desirable charge level is critical If the charge is set too high, production will be curtailed excessively; if the charge is set too low,

insufficient environmental protection will result Finding the right level

presents policy makers with both theoretical and practical challenges As with any regulatory system, policy makers must seek an overall target that balances control costs, benefits, and equity Theoretical and political questions of

economic efficiency and distributional “fairness” generally arise At a more

practical level, however, the linkage between charges and control must be

determined Estimating this relationship can be difficult, especially given our

limited experience with charge systems; and while experimentation with

various charges to find the right level might arguably be desirable, political

realities and the creation of uncertain economic expectations is likely to prevent such tinkering with the tax system

Adoption of Charge Systems

True pollution charge systems have not been adopted in the United States Although a few policies have embraced some “green tax” characteristics, these mechanisms are aimed primarily at generating revenue rather than

discouraging pollution The US approach to chlorofluorocarbons (CFCs) is

a good example In 1989, Congress enacted an excise tax on CFCs (16),

which deplete stratospheric ozone As part of the Montreal Protocol and the subsequent London Revisions of 1990, the United States agreed with other

nations to phase out all CFCs by the year 2000 (17, 18) The primary

mechanism for the United States to achieve its targets is a tradeable permit

system, however, and the excise tax does not materially affect either the level

or rate of the CFC phase down Instead, it is simply a charge on the sale of permits whose purpose is to ensure that any windfall profits associated with constrained supply accrue to the government rather than to private industry

(19)

Although many European nations? have implemented air- or water-pollu- tion charge mechanisms, these systems also function primarily to generate

revenues rather than to discourage pollution Even when mechanisms are

intended to create pollution-reduction incentives, the fee levels are often set too low to change producer behavior (20) One partial exception is the

Effluent Charge Law adopted by the Federal Republic of Germany in 1976

(21) However, even this charge is not a fully functioning market incentive;

"Included are the United Kingdom, France, the Netherlands, Sweden, Norway, Denmark, Finland, Italy, and Germany.

because the fee ¡s linked to uniform performance standards, marginal costs of

control are not equalized and full cost-savings potentials are not realized (22)

Collected Revenue Utilization

One major by-product of charge systems is a flow of financial resources from polluters to the government This financial transfer can be substantial; the Congressional Budget Office estimates that a $100 per ton charge on carbon dioxide (CO2) emissions (to address global climate change) could result in

more than $120 billion in annual revenues to the government (23) This raises

the obvious question of how such revenue should be used

At least three possible courses of action are readily identifiable: investments

in pollution control; deficit reduction; and reductions in other taxes (24) The

first option is to use the tax revenue to finance other environmental programs (such as mitigation and cleanup) without increases in other taxes The second

option—reducing the federal budget deficit—has obvious appeal; Paul O’ Neill,

of the Aluminum Company of America (Alcoa), suggested in the summer of

1990 that energy taxes could most effectively accomplish the dual goals of

reducing pollution and reducing the budget deficit (25) The most attractive option, however, may be the third—using pollution-charge revenue to offset reductions in other taxes |

Pollution charges are “corrective” taxes that actually reduce market inefficiencies (by discouraging undesirable activities, such as pollution, which

cause externalities) This effect contrasts sharply with that of most other taxes,

including corporate profit, Social Security and other payroll, and personal

income taxes, which tend to distort market functioning and generate ineffi-

ciencies by discouraging fundamentally desirable activities such as labor and

The corrective nature of pollution charges provides a “double dividend”

(27): a revenue-neutral tax policy change, combining the introduction of

pollution charges with the reduction or elimination of other taxes, would both protect the environment by reducing harmful emissions and offset market distortions associated with other taxes (for example, US personal and corporate income taxes generate distortions or pure losses of 20 to 50 cents for every new dollar of revenue collected) (28) This double dividend may be particularly relevant in today’s political climate where policy makers are reluctant to consider any new taxes

Comparing Charges with Tradeable Permits

Pollution charges are frequently seen as an alternative to tradeable permits,

another incentive-based mechanism While both possess advantages, their applicability depends upon both the specific environmental problem being addressed and the particular objectives of the public policy This section offers

a quick comparison of the two systems to highlight the circumstances under which each is likely to be most appropriate

I Permits fix the level of pollution control while charges fix the marginal costs of pollution control Under a permit system, policy makers determine how much total pollution can occur (through the issuance of permits), but

they cannot set bounds on expenditures for pollution control This strategy could be particularly appropriate for environmental problems with tight

margins of error or with marginal costs of control that do not rise dramatically

with increasing regulatory stringency Charge systems, on the other hand, control the maximum amount that a firm may pay for each increment of emissions, but do not dictate with certainty how much control will actually occur Such a tactic may be more suitable where the margin of error on

damages is not tight but the potential industrial impacts of “over-control” are especially great (28a) This could occur, for example, where small increases

in control costs lead to very large swings in production and employment

2 In the presence of technological change and without additional govern- ment intervention, permits freeze the level of pollution control while charges increase it Under a permit system, technological improvement will lower

pollution-control costs and permit prices, rather than emissions levels, unless

the government intervenes Such technological change under a charge system,

however, will both lower total pollution-control costs and increase levels of

control Although firms will choose to control more emissions and pay less

taxes, this can be offset by the expanded production that results from lower

operating costs

3 With permits, resource transfers are private-to-private while they are private-to-public with pollution charges.'* Under permit trading, firms choos- ing to emit pollution beyond their initial permitted level must make payments

to other firms who agree to control more than their initial share With charges,

payments for uncontrolled emissions flow to government For those who

believe that the private sector can utilize these resources more effectively, permits offer an advantage over charges Alternately, the government can earmark the revenue from charges for environmental investments, deficit

reduction, or reductions in distortionary taxes

4 While both charges and permits impose costs on industry and consumers, charge systems make the costs more explicit to both groups Both charges

and permits force firms to internalize the costs of their pollution, either through

expenditures on pollution controls or through cash payments (buying permits

“This assumes that permits are distributed free of charge to firms, not auctioned by the government In the latter case, permits and charges are quite similar in terms of these financial transfers In actual applications, tradeable permit systems have always involved free distribution

of permits to firms.

or paying charges) Charge systems, however, make these costs very visible

both to industry and the public While this may be problematic for short-term political reasons, it may ultimately be advantageous in that it can educate the

public about the costs and trade-offs associated with various levels of environmental control

5 Permits adjust automatically for inflation, while charges do not Because

a permit system’s “currency” is emission rights, price movements in the overall economy will not affect levels of emissions control Under a charge system, however, inflation would reduce the taxes (which are expressed in dollars per ton, for example) in real terms Firms would therefore control less An obvious way to resolve this problem would be to link the charge rate to some price index

6 High transaction costs can drive up the total costs of compliance, having

a negative effect under either system Transaction costs (e.g costs associated

with identifying willing buyers and sellers of permits or costs of tax collection)

can decrease the amount of trading that will occur in a marketable-permit

system (29) and the amount of pollution control that will be achieved with

a charge system

7 Permit systems may be more susceptible to “strategic” behavior If any

one firm controls a significant share of the total number of permits, its activities may influence permit prices Although no magic cut-off point exists,

it is unlikely that firms could engage in price-setting behavior if they controlled less than 10% of the market (30) If other firms present credible threats of

entry to the market, it is less likely that anticompetitive behavior can thrive (31)

APPLICATIONS OF POLLUTION CHARGES

Pollution charges can address a variety of environmental problems at various levels of government The list of potential applications includes many forms

of air and water pollution, as well as many solid and hazardous waste problems

In the remainder of this paper, we consider two particularly promising areas

for action—greenhouse-gas reduction and cleaner energy production—and briefly cover other applications

Greenhouse-Gas Reductions

Few of the environmental problems that have arisen since the beginning of the industrial revolution have posed greater risks or uncertainties than the threat of global climate change due to the greenhouse effect If emissions of carbon dioxide (CO)) and other greenhouse gases (such as methane and

nitrous oxides) continue to grow at current rates, many scientists believe that

global mean temperatures may rise by 2 to 5 degrees Fahrenheit over the next